The Internet was abuzz last week over the news that the Department of Justice filed suit against Apple and six book publishers for conspiring to raise ebook prices. It’s amazing to think that just over a decade ago you couldn’t find an article that spoke about Apple without using the word “beleaguered” and Microsoft was the subject of lawsuits over anti-competitive actions. Now Apple is one of the most valuable companies in the world and it’s their time to face the Department of Justice.

As with any Apple story, there is a ton of blog and media coverage. In this case there are articles saying that Apple will win and others saying they’ll lose. I’m not going to link them here, they’re easy to find. What I will say is that so far we only have half the story, the DoJ’s side. And as with any lawsuit, the initial complaint should be a compelling story. In this case it’s a doozy. Reading the DoJ’s complaint is a legal page turner, which isn’t a very high standard. But I wanted to present the overall story so you can understand the lawsuit and why it matters to social media practitioners. Sorry for the length here, but hopefully you’ll find this case as fascinating as I do. The original complaint is 36 pages, so I’m saving you a little bit of time.

I. The Law and Markets

Even though Apple and the publishers have been sued under US laws that prohibit anticompetitive actions, this is not a lawsuit about a monopoly. The two tend to be confused by the media (and some “legal experts” who have blogged that Apple can’t lost this lawsuit because Amazon still controls the majority of ebook sales…completely missing the point). Here, the US has sued Apple under section 1 of the Sherman Act which states, in part:

Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal.

The DoJ alleges that Apple and the six publishers entered into a conspiracy that restrained trade. That phrase “restraint of trade” is Legalese for harmed competition–a cornerstone of laws that protect competition. The analysis will not be on whether a competitor (e.g., Amazon) was harmed, but whether the entire market where competition takes place was harmed. Has the DoJ laid out a case that shows competition was harmed? Let’s see.

To understand the DoJ’s case we must first learn a little about how books are sold in our current market. To do so, I’m linking to some great illustrations done on the Macstories blog post Understanding The Agency Model And The DOJ’s Allegations Against Apple And Those Publishers. That blog post focuses more on a timeline of certain events and explaining these models while I’m trying to tell more of the story, so it may be worth checking it out after. But here is the traditional wholesale book selling model.

In this model, the publisher sells to the bookstore and the bookstore sells to the customer. You can see the example numbers in the slide but the important thing to know here is that the Retailer (bookstore) is free to sell the book for any price they want. If they buy a book from a publisher for $11 they can turn around and sell it to Joe Consumer for $25 or $50 or $1 or $1,000. Whether that book will sell at that price is up to the retailer to determine, but they are technically free to make those changes. That’s why you have large book stores who sell books at 30% or 40% off cover price–they are still making a slight profit off these books which scales with their large volume.

When Amazon brought the ebook market to the mainstream they used the wholesale model. They bought ebooks from the publisher and then sold them to the customer at a price set by Amazon. Because ebooks cost less to manufacture and distribute, their wholesale cost from the publisher was lower than a print book. But since publishers still wanted to make healthy profits, they didn’t price the ebooks at $1 or $2 for new books by popular authors. Instead, they typically charged $9 to $10 for the ebooks.

Amazon wanted to make a splash in the ebook market so they priced all bestsellers at $9.99. That splash worked. In only a few years, ebook sales accounted for 10% of all fiction book sales in the US.

This scared the book publishers. No, not scared; it terrified them. First, publishers were faced with declining revenue. When they sell a brand new book by a popular author it could be anywhere from $11 to $14 or more for the physical version. The electronic version was $2 to $6 less. So for every ebook that was sold instead of a physical copy, the publisher earned less revenue. Arguably, they should have made higher profits given the decreased production costs, but any large business like the big six publishers will be equally concerned about showing revenue and profit to their shareholders and the market. So selling more ebooks at $9 or $10 scared publishers.

Publishers were also scared that consumers might grow accustomed to this $9.99 price point. As more customers expected new books to be at this price, there could be further market pressure for publishers to decrease their wholesale pricing on print books or ebooks. This would lead to even less revenue. And it could also lead to an even higher rate of ereader adoption–to have 10% of the market shift in a few years was one thing but to have it go to 25% or 50% could dramatically impact the publisher’s bottom line.

II. The Alleged Conspiracy

In late 2008, some of these publishers started talking to each other about the Amazon threat. They were scared of the $9.99 price point. And they were also scared that at some point Amazon could just replace the book publishing companies altogether. But they didn’t know how they could address this ebook threat.

Then Apple entered the picture. In 2009, Apple was putting plans in motion to announce the iPad in a year. One of those efforts was looking at how the iPad could compete with Amazon’s Kindle for ebook sales. Initially, Apple thought they could compete by using the same model as Amazon. But when they looked into that model they saw how small the margins were with wholesale books (while Amazon typically sold bestselling ebooks at their list price, they made money on other books to be profitable). Apple was not interested in small margins. So they started talking to publishers and saw an opportunity.

Apple realized that they could work with book publishers to completely change the ebook market. The first thing they would do is have the publishers sign up to sell their ebooks through iTunes via an agency model rather than a wholesale model. Here’s what that agency model looks like:

The biggest difference is that the publisher is the one who sets the price. Apple earns 30% of that price, no matter what it is, but Apple has absolutely no control over the price of the ebook. From Apple’s perspective, this is ideal as they will consistently make 30% profit on any ebook sale. Unlike the wholesale model, there is no management of pricing required–you don’t need to charge more for new books and then start offering discounts before you ultimately move a book to a clearance shelf just so you can make some money and clear the space for the next batch. And from the publisher’s perspective, this is the perfect solution to the $9.99 Amazon problem since now the publishers can push up the prices on new books and break the ereading masses from expecting to pay less for ebooks.

But there’s a problem with the agency relationship and changing the business model for the publishers. It will only work if they all do it at the same time. If one publisher goes to the agency model but the others don’t then that agency publisher is in trouble. The other publishers’ books will continue to be sold for $9.99 and the agency publisher will be forced to continue pricing their book at $9.99 in the iTunes store. But since they are under an agency relationship, that $9.99 sale will only get the publisher $7 since Apple will take $3. Now all the other publishers will continue to sell their ebooks under the wholesale model for $10 while the agency publisher will only get $7. Sure, the agency publisher could increase the price of their book to $14 so they make close to the original $10 after deducting 30%, but if you have a bunch of bestsellers in a store for $10 and a few for $14, I think you know what will happen to those $14 books.

The publishers knew that the only way for this model to succeed was for everyone to do it. So they started talking to each other secretly. The CEOs of these large publishing companies met in secret. Sometimes at exclusive dining rooms in elite restaurants. They had secretive phone calls which they refused to discuss with their co-workers over email. When they did compose emails about their plans they asked people to “double delete” the message. (Lawyer’s note: ouch.) They also shared confidential business plans with each other in order to cement the joint relationship. And here’s something that’s going to be difficult to explain away if true–while Apple was negotiating the six different contracts with the six publishers, they were telling all the publishers about the other contract negotiations. These are not the kinds of behavior you would expect to see in a competitive marketplace.

But true to any Apple presentation, there’s one more thing. Apple and the six publishers jointly agreeing to a new agency model for the iBookstore wasn’t enough to change the entire market. All that would do is ensure that the six publishers could raise prices for books sold through iTunes. To truly change the entire business, the publishers would need to change their relationships with other ebook sellers (Amazon). In earlier versions of the Apple Agency Agreement there was a clause that explicitly called for just such an action–all publishers would adopt an agency relationship with other ebook sellers. Perhaps because of timing or some legal concern, the final version of the Agreement changed this clause to a strange form of a Most Favored Nations clause.

Most Favored Nations, or MFN, clauses in a contract will provide the best possible pricing to a party. If I have a contract with a Seller that has a MFN clause and the Seller lowers the price to someone else, I get the lower price.

Apple’s strange MFN clause was for an agency model, so they couldn’t just talk about the price of an ebook sold to Apple (the publisher sets the price for the sale, after all). Instead, the MFN clause made publishers promise that they would sell their ebooks on the iBookstore for the lowest price that ebook was sold on any other site. Meaning if they continued to sell the ebooks wholesale, giving pricing control to the other ebook sellers (Amazon), then the publisher would have to match those prices and take the revenue hit (they will only get 70% of the price set by someone else). The effect was the same as the earlier language–publishers would need to switch their ebook sales to the agency model across the board and immediately.

The publishers all signed their contracts with Apple on January 24-26, 2010. On January 27, Apple announced the iPad. Part of that announcement was the iBookstore and in Jobs’ presentation he showed current bestsellers sold for $15. One Wall Street Journal reporter asked Jobs why consumers would buy a book on the iBookstore for $15 when they could buy it from Amazon for $9.99. Jobs’ replied “that won’t be the case…the prices will be the same.”

Macmillan, one of the six publishers, decided to press Amazon on the new model immediately. They told Amazon that they would need to adopt an agency model or Macmillan would pull their ebooks from the Kindle store. Amazon refused and dropped Macmillan’s ebooks. The other publishers started telling Amazon they would be doing the same. Amazon, seeing this was a losing battle, caved to the publishers and adopted an agency model with a nasty note on Amazon.com about what the publishers were doing. This all happened within 4 days of the iPad announcement.

Almost immediately, ebook prices went up. The DoJ only presented some average numbers, but even those are compelling. Within one year of the switch, bestseller prices went up 10%. Trade publications (think mass market paperbacks but in ebook format) averaged 30% to 50% higher. And this is in a market where the cost to produce such ebooks did not increase and the number of people purchasing ebooks dramatically increased. In other words, exactly the kind of market you would expect to see prices fall or stay steady, not go up.

III. The Proposed Settlement

Fast forward a couple of years and a lot of DoJ work and you end up with the current lawsuit. When the DoJ filed the lawsuit they also announced that three of the publishers were agreeing to the DoJ’s proposed settlement, the rest would need to be forced by the lawsuit. The terms of the settlement were as follows:

Publishers must terminate the Apple Agency Agreement

They must also terminate any other agreements that restrict the ability of a seller to set an ebook price or if the contract has an MFN clause

Any new ebook selling contract must avoid collusion as detailed in the complaint

For 2 years, publishers cannot prohibit discounting by ebook sellers

Sellers like Amazon may stagger the termination date of ebook deals with publishers so that publishers are renegotiating their contracts at different times

Publishers must notify the DoJ before entering into joint publishing ventures (which could be a form of collusion)

Publishers must give copies of their ebook selling contracts to the DoJ if signed after January 1, 2012

Collusive and retaliatory actions by publishers are prohibited

Publishers may negotiate marketing programs and limited agency programs where total discount is limited but seller still retains pricing control

Each publisher must have an Antitrust Compliance Officer and must provide 4 hours of antitrust training to executives

IV. Why it Matters

Now, why should you care about all this? First, I hope you found it an interesting story and you can see the case laid out by the DoJ. If all of this is true then Apple and the publishers not only harmed Amazon but they harmed the entire competitive marketplace. A new model was forced upon us all that resulted in ebook readers paying more for the latest Dresden Files novel, among others.

Social media has changed our world not only because of platforms making it easier to connect with each other but also because we can more easily share content. A large part of that has been because physical content has moved to digital. And when large bodies of content make that transition we tend to see the industry around that content rebel against that change.

In the music world, the industry switched to digital content when they embraced CDs–it took a few decades for networked computers to make it easy to share (usually illegally) those files but the genie was already out of the bottle. Even then, the RIAA tried to regain control by suing music pirates; a strategy that has failed to stop music piracy. Legitimate channels and affordable pricing has done more to curtail piracy than questionable tactics like lawsuits.

In the ebook world, the printed page is going digital and here was a chance for the old guard to try and regain control. In this case they decided to force higher prices rather than embrace new technology. And they may have done so illegally. We can understand their fears at the same time we can condemn it–publishers may be very afraid of being replaced by direct publishing altogether.

Indeed, one of the final straws that forced the publishers to go in with Apple was when Amazon announced they would sell books directly by authors and pay the authors 70% of the selling rate–in essence trying to flip the agency model against the publisher. The math on this is intriguing. A typical author earns 10%-15% of the cover price on a hardcover book. If that book is sold for retail at $30 then the author will make $3 to $4.50 per book.

That same author could sell their book directly for $7 through Amazon and earn $4.90. The market may still be too small and too full of unproven authors to be viable right now, but the time is coming.

Social media professionals know that the true power of our new world is that the distance between people is decreasing. That’s also true for the distance between companies and customers as well as the distance between creative professionals and their potential audience. But what we must be careful of is the temptation for old technology and leaders to take one more lap around the profit pool at the expense of everyone else.

Change can be scary. But actions taken to harm competition can be even scarier.

IMPORTANT DISCLAIMER

SoMeLaw Thoughts are entirely my own opinion about social media legal issues and not the statement, opinion, or in any other way affiliated with Dell.

This means I could be completely wrong about everything I post here. Sure, I’ve practiced for over ten years in technology law and have supported Dell’s social media team for a fair amount of time, but if you get five lawyers in a room and ask a question you’re likely to get seven different opinions. Oh, and it’s a really boring room. And someone will probably start quoting Latin. So I could be totally wrong here.

This is also not specific legal advice for you. I don't know you. Even if I know you I didn't write this for you, I wrote it for the blog and you're reading it. You want legal advice? Hire an attorney! A good one.